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Last year Pakistan, following the lead of its neighbor and archrival India, detonated a nuclear device. Five months ago the Paris Club dropped a bomb of its own on the country.
In an eight-sentence memo creaking with dry bureaucratese, the group of 18 creditor nations that orchestrate official debt reschedulings declared that, as part of any agreement to reschedule $3.3 billion of Pakistan's official debt, the government would have to renegotiate an additional $620 million in Eurobonds. Without the group's help, a reeling Pakistan faced certain fiscal catastrophe.
Furious, Pakistan has resisted complying, hoping to remain current on its debt. It paid interest in late May and most analysts believe it can meet a $150 million principal payment due this December. Fewer are sanguine about its ability to pay off a $300 million Eurobond that comes due in May 2000.
"We are royally pissed," says a Pakistani government official. "We were set up to send a signal to the fat cats."
The fat cats, the sovereign bondholders who were being asked - make that told - to share the burden of emerging-country debt restructurings, are no happier. Until now, official bail-outs of developing countries left bond investors unscathed. "Bailing in" bondholders could drag them into the mire of reschedulings and force them to write down some of their holdings. Though the idea has been kicked about for years, this marks the first time it is about to be put to the test. The big concern, expressed by both borrowers and creditors, is that if countries are forced to restructure their bonds, they'll find themselves shut out of the capital markets in the future.
"Bail-ins don't make sense," asserts William Nemerever, a portfolio manager who runs more than $1 billion in emerging-markets debt at Grantham, Mayo, Van Otterloo & Co. in Boston. "They will drive up the cost of capital and keep developing countries out of the bond markets."
The Paris Club's proposed reform is a critical component of a larger debate. Ever since the Mexican peso crisis of 1995, policymakers in government and at the International Monetary Fund have been working to create a new "global financial architecture." This somewhat grandiose and still-amorphous construct embraces policy refinements and new initiatives meant to ensure greater stability in financial markets while promoting growth in developing countries. From the commonplace to the controversial, the proposals being mooted include the use of capital controls, the approval of currency boards, the creation of a global central bank, as well as greater banking transparency.
But the idea of a bail-in - at some time, in some form - has lately gained great momentum. Politics and diplomacy help explain why. From Mexico to South Korea, rescue efforts led by the IMF and backed by the U.S. and its Group of Seven partners have caused political dustups. Fueling the debate is the idea that rich investors were let off the hook while ordinary taxpayers were asked to foot the bill - a policy, rife with moral hazard, that only encourages more reckless lending in the future.
European countries, whose banks have been big lenders to the emerging markets, have beat the drum the loudest for bail-ins. But the U.S., where Congress has fought bitterly over IMF policies, has begun to support the concept as well. In mid-April Treasury Secretary Robert Rubin argued in a speech that "market discipline will work only if creditors bear the consequences of the risks that they take," and that "when both are material, claims of bondholders should not be viewed as necessarily senior to those of banks." At the IMF spring meetings in late April, deputy secretary Lawrence Summers said that "public sector financing of private withdrawal is unacceptable." In other words, the claims of private and official creditors must be treated on comparable terms. Policymakers will debate the prospects for bail-ins at this month's G-7 meeting in Cologne, Germany - already dubbed the financial architecture summit.
The Paris Club's move against Pakistan was just the first concerted push by official creditors for a bail-in. Others are in the works. The IMF urged Ukraine to hold off servicing its Eurobond payments until the bonds could be included in a broader restructuring. (In May Ukraine did begin negotiations on restructuring a $155 million local-currency-linked bond underwritten by ING Barings that falls due this month.) Earlier this year the IMF had pressed Romania to do the same, but then backed off once NATO began its bombing campaign against neighboring Yugoslavia.
If bail-ins become standard policy, it would mark a stunning reversal in a long-standing capital markets tradition. For more than 60 years, sovereign bonds have been sacrosanct, exempt from any reschedulings and all but invulnerable to default. When a debt crisis struck, Western governments pumped in money and commercial bank and official debt was renegotiated. Just as often, developing countries used at least part of the new cash to pay off their bondholders.
But today sovereign bonds represent a far greater share of total emerging-markets debt. For the past five years they've comprised more than half of all the external borrowing by developing countries. That, officials say, will make it extremely difficult, if not impossible, to organize any future rescues without including them. Says Malvina Pollock, the World Bank's observer at the Paris Club: "Even if we went to 100 percent restructuring on Paris Club debt, we couldn't close Pakistan's financing gap. We had to touch something else."
Financial stability has returned to many emerging markets in recent months - the recovery in South Korea continues to astound - but a number of countries, including Ecuador, Moldova, Russia and Ukraine, remain deeply troubled. Thus the three-way tug-of-war between G-7 policymakers, developing countries and bond investors may soon reach a decisive turning point.
"The official sector feels that now is the time to push for a change in the treatment of sovereign bonds, but it is a high-stakes play," says Lee Buchheit, a debt restructuring expert at Cleary, Gottlieb, Steen & Hamilton, a New York law firm that represents Russia and Ecuador. At a time of market instability, Buchheit argues, changing the rules by forcing restructuring could trigger the very contagion policymakers want to avoid.
Adds Timothy Geithner, U.S. Treasury undersecretary for international affairs, "We want to shape expectations ahead of time to help reduce the risk of crisis, and we want to have flexibility when things fall apart, so that we don't face the choice of lending more money or risking financial chaos." In other words, if lenders know they won't be bailed out, they'll lend more cautiously in the future. That prudence, combined with orderly workout procedures, should mean that G-7 governments won't be forced to intervene every time emerging-markets debtors get into trouble.
That gives scant comfort to international bondholders. They fear that even allowing for the possibility of a mandatory restructuring of sovereign bond debt means that it will probably happen. Restructuring can involve debt exchanges, lengthening maturities in exchange for higher yield, or writing down a portion of the principal.
When their next payment comes due, the most vulnerable debtors may have no alternative but to accept a bail-in, lest they be forced to the brink of default. As Moody's Investors Service notes in a recent report, "It is likely that one, and probably more than one, sovereign bond issuer will default within the next year or two." Faced with the stark choice between default and debt restructuring, debtors, official creditors and investors may all agree, finally, that restructuring is the lesser of two evils. Or as Matthew Fisher, chief of the IMF's capital accounts issues division and one of the authors of a recent IMF report outlining bail-in options, says, "The apparent halo effect surrounding sovereign bonds is no longer sustainable."
Until Mexico's default in 1982, commercial bank debt made up almost all lending to poor countries. When banks were forced to restructure their emerging-markets loans, they suffered heavy losses and lost their appetite for such lending.
Since the early 1980s, in fact, banks have made virtually no balance-of-payments loans, largely restricting lending to trade credits. Developed countries excluded the few outstanding bond issues from the 1980s emerging-markets debt restructuring; this allowed developing countries to turn to bond markets for financing in the early 1990s. Investors were eager to snap up the high-yielding, seemingly riskless paper. After all, while banks and official creditors have repeatedly rolled over their credits during emerging-markets crises, bonds always claimed pride of place. Finance ministers scrupulously paid off their bonds to avoid the risk of being shut out of the market.
As a result, sovereign debt received an implicit, though completely unofficial, senior status that helped spark a dramatic spurt in emerging-markets bond issuance. In 1992 just $6 billion of such bonds were issued. In the first seven and a half months of last year, up until the day the ruble collapsed, emerging-markets countries sold bonds worth $40 billion. That was something of a triumph, given that the markets were still jittery about Asia.
The privileged position of these bonds became clear during the 1995 Mexican peso crisis. Mexico used loans from the IMF and the U.S. government to retire the $28 billion worth of short-term, dollar-denominated tesobonos coming due. If Mexico hadn't been bailed out, the country, with only $6 billion in international reserves, would have been forced to restructure or default on the bonds. At the same time, though, many foreign banks suffered substantial losses on their loans.
Moral hazard resurfaced in the 1997 Asian financial crisis, when many banks and bondholders got away scot-free. In South Korea, for example, the government had only $10 billion of hard-currency reserves in December 1997, even as it faced short-term foreign bond and bank debt obligations of $26 billion. Then came the $57 billion international rescue package, put together by the IMF, the U.S. and an international consortium of banks. The country was propped up, Seoul avoided declaring a moratorium on its sovereign debt, and all foreign creditors - banks and bondholders - were paid in full.
As bond investors breathed a sign of relief, many others, including top policymakers and politicians, were outraged. Why should public money line the pockets of private bondholders?
"This is basically a subsidy issue," says Morris Goldstein of the International Institute of Economics. "The current balance of power tilts too much in favor of the official sector subsidizing private creditors."
Adds attorney Buchheit: "In Asia we saw that bailouts began to lose their effectiveness. So the official sector concluded that it must disabuse investors of the idea that these bonds have seniority, or the lenders will show no restraint." Reckless lending means more crises and more bailouts. And as each rescue mission is less successful in restoring confidence than its predecessor, the bailouts inevitably become bigger, more expensive and more unpopular.
During last year's bitter battle in the U.S. Congress over a proposed increase in IMF funding, opposition to publicly financed bailouts reached a crescendo. Says Texas Congressman Ron Paul: "It is immoral that Congress taxes a single working mother so that the federal government can bailout the bad decisions of foreign lenders and domestic investors." In the end, Republicans almost killed a $17.9 million appropriation for new IMF funds to deal with future financial crises.
The concept of "comparability" lies at the heart of the Paris Club's bail-in proposition: All external debts should be treated on comparable terms. In the past, Paris Club creditors had always forced commercial bank lenders to renegotiate their loans on terms comparable to official credit restructurings. The group's ultimatum to Pakistan was its first attempt to extend comparability to bondholders. Pakistan would have to reschedule the $620 million in Eurobond debt that comes due before December 2000. "The Paris Club has not changed its approach," says one of its representatives. "What has changed is the environment under which comparability has been applied. In the past five years, the place taken by bonds has increased very fast. It is logical that comparability of treatment applies to those categories of creditors as well."
At the same time, the IMF and the G-7 are calling for a broad revision of all new emerging-markets sovereign bond contracts to facilitate their restructuring. Currently, restructuring standard U.S.-style bond contracts requires the unanimous approval of all holders, but with investors scattered all over the world, that is a practical impossibility. Under this proposal new contracts would include majority-action clauses that would allow less-than-unanimous bondholder approval for restructurings. The proposed introduction of sharing clauses would prevent individual bondholders from tying up the issuer and other creditors in litigation.
For their part, emerging-markets governments take another view of bond restructuring: They insist that if bond contracts are to be revised, all countries, including major creditor nations, should be subject to the changes. Otherwise, they fear the emergence of a two-tier bond market, with emerging-markets debt on the bottom. "It is a complicated issue," says Brazil's central bank president, Armínio Fraga. "We are waiting for the developed countries to take the lead on this." The odds are slim, though, that a G-7 nation will actually do so.
Yet G-7 policymakers have other moves in their repertoire. The Paris Club move against Pakistan, and Ukraine's IMF-prompted bond restructuring, along with the threat of action against other countries, could act as catalysts to change investors' expectations that bondholders will always be bailed out. Such a shift could consequently persuade both issuers and investors that a restructuring might actually happen, in which case it would be in everyone's interest to have procedures in place to prevent a totally chaotic debt renegotiation. New bond contract clauses, some argue, could serve that purpose well.
In a further attempt to make sure its message is heard, the IMF has included revised bond contracts as one of the conditions developing countries must meet to qualify for the Fund's new contingent credit line. This line of credit, extended to countries with sound economies, is designed to help defend against potential balance-of-payments problems.
Markets, let's face it, can be puzzling. The January ultimatum to Pakistan sent bondholders reeling, while bonds from Ecuador, Moldova, Romania, Russia and Ukraine fell further as investors worried that they, too, would be forced to restructure. The securities quickly bounced back, although Ukraine's slipped last month on word of its restructuring talks.
The recovery comes as stronger economic news is being reported in much of the developing world. But the renewed market vigor also reflects a hunch among traders and investors that policymakers will be unable to push through any significant reforms. To the official sector this bodes ill, as the specter of moral hazard reemerges. Latin American countries are coming back to market after a long hiatus, successfully issuing $17 billion through May of this year, meeting an audience of yield-hungry investors. In recent weeks even the benchmark bonds of Pakistan and Russia have gained steadily. "The markets are in denial," says Gary Evans, head of Mendocino Capital, a research and trading firm. "This is the emerging-markets version of irrational exuberance."
Early signs of recovery notwithstanding, the emerging markets remain fragile. They need capital, not just to refinance maturing debt, but to build their economies. The danger is that, by forcing changes to the status of bonds, the official sector could inadvertently deny these countries money when they need it most. "If the IMF and U.S. Treasury treat bondholders the way banks were treated in the 1980s," says David Mulford, Credit Suisse First Boston chairman international, "the markets would be damaged into the next century."
Citibank vice chairman William Rhodes voices a common concern that bail-ins could effectively drain liquidity from the bond markets of some emerging countries. Says Rhodes, who spearheaded the Latin American bank debt restructuring of the early 1980s: "The problem today is not excess liquidity, low credit standards and spreads that don't reflect the risks, as it was three years ago. The challenge today is how to incentivize flows to countries that are doing the proper thing."
Indeed, confronted with spirited opposition from investors and issuers, Western policymakers have toned down their rhetoric. The IMF and most creditor nations now explicitly call for a "case by case" approach to bail-ins, as U.S. Treasury Secretary Rubin suggested. France's finance minister, Dominique Strauss-Kahn, originally favored a fairly rigid, Paris Club-type approach to bondholder bail-ins but has since come around to Rubin's milder proposal. Says Strauss-Kahn: "We need to improve burden-sharing, but on a case-by-case basis. And we should always favor a voluntary, market-based approach." And in April the IMF extended an olive branch to money managers when it announced that it would seek "private sector input" for any initiatives on altering bond contracts. Translation: The agency will at least listen to investor concerns.
"Officials are looking for a third way between providing blanket guarantees for ever-bigger bailouts and letting nature take its course," says Barry Eichengreen, a University of California at Berkeley economist.
As they search for that third way, political pressures will invariably be brought to bear. Many observers believe that official rhetoric about the need for bail-ins and prudent lending notwithstanding, reform will only come when a developing country is compelled by the official sector to restructure its sovereign bond debt. "If Pakistan is forced to reschedule, there will be a message," says IIE's Goldstein.
How will the Pakistan story be resolved? The World Bank's Pollock offers this scenario: "The moment that Pakistan starts paying bondholders, the Paris Club deal will fold, as will Pakistan's IMF agreement. Then the whole house of cards will fall." For now, the IMF has said Pakistan can pay interest on its bonds, but not principal. That could delay the showdown to the end of the year.
The official sector has plenty of other test cases to choose from. As a country in even worse financial shape than Pakistan, Ukraine was particularly vulnerable to IMF pressure. The Ukrainian government is now offering to swap 80 percent of the $155 million bond for new three-year Eurobonds and pay the rest in cash. Cash-strapped Ecuador could join Pakistan as another target of bail-in reform when its representatives meet with the Paris Club early next month. Russia faces hefty Eurobond payments this summer. Those countries might be left with no choice but to restructure their debt.
Some reform seems inevitable. Fortunately, issuers such as Argentina, Brazil or Mexico - which have the largest proportion of their external financing in bonds - are stable for now. But in coming months one troubled debtor after another will confront major deadlines on external debt. They may then face that exquisitely painful choice: Restructure sovereign debt or default - and thereby risk losing access to global capital markets for a very long time.